Penalty Assault

March 01, 2011
Negligence, substantial understatement of tax penalties on IRS radar.

By Robert A. Caplan, CPA

As the IRS steps up efforts to ensure accuracy-related penalties are considered during correspondence audits, negligence and substantial understatement of income tax and in-person audits, it’s important for CPAs to have a full understanding of the subtleties of these penalty provisions.

Along with these efforts, the IRS also is becoming increasingly stringent in allowing reasonable-cause exceptions to the penalties, especially related to substantial underpayments. However, as clients usually don’t understand the complex subtleties of these penalty provisions, the CPA is often being asked to pay the penalty—or face the possibility of losing the client.

To protect themselves, CPAs should consider adding language to the engagement letter detailing the frequent imposition of these penalties and the client’s responsibility for payment.

Review of the Statute
Internal Revenue Manual Sec. 6662(b) imposes accuracy-related penalties under certain conditions. This article focuses upon two of these conditions, which seem to be the most problematic.
  • Negligence or disregard of rules or regulations 6662(b)(1); and
  • Substantial understatement of income tax 6662(b)(2).
If these conditions are met, the taxpayer is subject to a penalty of 20 percent of the underpayment to which this section applies.

According to IRC Sec. 6662(c), “‘Negligence’ includes any failure to make a reasonable attempt to comply with the provisions of this title, and the term ‘disregard’ includes any careless, reckless or intentional disregard.”

Although this definition of negligence is less than precise, courts have typically applied a common law definition: “Failing to do what a reasonable and ordinarily prudent person would do under the same or similar circumstances” [Cook, John, “The Accuracy-Related Penalty (Part1)” The Tax Advisor April 2010, P. 250].

While the regulations do not define negligence, they do provide examples of negligent behavior, including failing to keep adequate books and records and to substantiate items properly [Regs. 1.6662-3(b)(1)].

The sophistication of the client and the utilization of professional advice are factors in determining negligence. As the IRM states, “Negligence is strongly suggested if a taxpayer fails to make a reasonable attempt to ascertain the correctness of a reported item which would seem to a reasonable and prudent person to be ‘too good to be true’ under the circumstances” [].

Note that according to the IRM, the “negligence penalty will not be assessed solely due to the taxpayer’s failure to appear for an audit or respond to an inquiry or correspondence” [].

Substantial Understatement
The IRC defines this as being when the understatement exceeds the greater of 10 percent of the tax, as adjusted, or $5,000 [Sec. 6662(d)(1)].

For C corporations, substantial understatement is defined as the lesser of 10 percent of the tax, as adjusted (or, if greater, $10,000), or $10 million.
The substantial understatement penalty compares the tax on the return as filed to the return as corrected or amended by the IRS. Only when the change in tax exceeds these calculations is the penalty applicable.

Even though this test appears to be mechanical, the penalties can be reduced where the taxpayer or the taxpayer’s representative has substantial authority or a reasonable basis for the return filing. This authority must be disclosed on the return in conformance with the regulations.

Reasonable Cause Exceptions to the Penalty
The determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances. The taxpayer has the burden of proof. The following are the most common reasonable cause exceptions.

Reliance Upon the Professional
There are a number of cases that focus on the reliance of a professional as a reasonable cause for waiver of the penalty. Most of these cases focus on the taxpayer’s qualifications and whether it was reasonable to rely on faulty advice from a tax professional. Generally, a taxpayer who has a perceived level of sophistication or knowledge can’t claim to rely on the advice of a professional adviser. “Advice” refers to written or verbal communication.

Comparison to Tax Abuse Cases
One approach that has seen some success is positioning the taxpayer’s omission as minor in comparison to a tax-protest case or to an unreasonable stance, such as deducting all personal expenses [Irwin, Pennel Phlander, (TC Memo 1996-490)].

Acting in Good Faith
A reasonable cause letter will ideally include a statement that the taxpayer acted in good faith and the contention that the reasonable cause exception should apply [Sanders, Dean (TC Memo 1999-208)]. This exception has been successfully applied in cases such as a taxpayer failing to report one of fifteen K-1s or inadvertently not reporting the corrections on a 1099.

Unfortunately there appears to be no standard for whether a reasonable cause penalty abatement request is accepted. According to the 2010 Taxpayer Advocate report to Congress, the IRS was faulted for not remodeling the Reasonable Cause Assistant program, a computer-based support tool for determining when reasonable cause exists. The Taxpayer Advocate found that only 2 percent of penalties are abated when the Reasonable Cause Assistant is used.

So, as it seems the IRS will continue its pursuit of accuracy-related penalties (see Treasury Inspector General for Tax Administration Report, June 2010,
CPAs must stay on top of educating their clients—and themselves.

Robert M. Caplan, CPA is a sole practitioner in Foster City and a member of the CalCPA Taxation and Estate Planning committees.

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